12/03/2023

ASHESI UNIVERSITY
DEPARTMENT OF BUSINESS ADMINISTRATION
BUSA 321: INVESTMENTS

Taught by

A. Essel-Anderson

EQUITY VALUATIONS
Overview of the valuation process
Valuation analysis
Valuation methods

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Objectives
• Perform fundamental analysis
• Model vulnerability to bankruptcy using Atman’s Z-score
• Model the value of a business using various valuation approaches
• Model the premium to be paid for a share of equity stock using EVA

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Business valuation
Valuation – the process
• Business valuation is the process of putting
economic value on owners' equity in a business

Value – the end result

• The theoretical price that interested buyer(s) and
seller(s) are most likely to conclude for the
business
• It is an estimate of the most likely price that will be
paid
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Understand the Purpose

The valuation process
Analyse the economy, industry and
company
A good understanding of
the purpose of valuation
and analyses of the general Normalise financial data
economy, industry, and
company conditions is
useful in establishing the Determine value
premises of valuation and
selecting the appropriate
valuation methodology Communicate results

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Understanding the Purpose

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Reasons for valuation

• Valuations that result in arm’s • Valuations that do not result in
length transactions: arm’s length transactions:
• Acquisitions • Estate and gift tax valuations
• Mergers • Employee share option plan (ESOP)
• IPO’s • Litigations, including shareholder
• Venture capital investment in start- actions and equitable distribution
ups actions

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Premises and Standards of Value

• Standards (or bases) of value – • Premise of value – circumstances
underlying measurement objective under which value is determined
• Fair market value • Going concern
• Investment value • Liquidation
• Intrinsic value • Assemblage of assets
• Orderly disposition

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Valuation Analysis

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Why should you carry out a valuation

analysis?
➢Success of the subject company is linked to conditions in
the broader economy, industry, company’s internal
environment
➢Valuation involves estimating future income stream and
rate of return which are affected by variability in
economic conditions
➢The valuation analysis helps in assessing the risk
associated with the subject company
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Which areas are relevant?

Broad-base analysis Firm-specific analysis

Global economy Historical financial

performance
Domestic economy

Industry Equity value

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MACROECONOMIC
ANALYSES
Global economy
Domestic economy
Industry

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Macro-economic analysis
Global ➢Deciding on relevant
Economic
Factors economic facts and scope of
Domestic
analysis:
Economic ➢Size of business
Factors
➢Geographic spread of
customers
➢Nature of competition
Company
performance
➢Source of inputs/products

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The Global Economy

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The Global Economy /1

Global competition

Political developments What global factors affect

Developments in international financial markets the prospects of the firm?
Forex rate and international purchasing power

Growth and sustainability

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The Global Economy /2

• Global competition – low-priced imports, innovation, cheaper and reliable
source of top-quality inputs
• Political developments – trade and investment policies, forex control, public
debt management, free capital flow, political turmoil around the world
• Developments in international financial markets – integration of
international financial markets, cross-border stock listings, cross-border stock
offers, financial crisis
• Forex rate and international purchasing power – volatility in forex rate of
major trading currencies, currency crises
• Growth and sustainability – GDP growth of relevant economies; emerging
markets
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The Domestic Economy

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The Domestic
Economy
GDP growth

Employment

Inflation
What domestic
macroeconomic factors affect
Interest rates the prospects of the firm?
Sentiments of consumers and producers

Central government monetary and fiscal policies

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GDP growth
• Consider the growth rate in GDP
• When GDP is growing rapidly, the economy may expand and
business may earn more sales revenue
• We may also consider industrial production

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Employment
• Consider unemployment statistics of the country
• The degree to which the economy is operating at full capacity by
affects the prospects of businesses
• Consider not only unemployment rate of people but also factory
capacity utilisation

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Inflation
• Consider the rate of inflation in the economy
• A level of inflation is needed to stimulate the economy
• With high inflation, demand for goods and services exceed
productive capacity causing prices to rise
• High inflation can also cause the cost of capital to rise

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Interest rates
• Consider interest rates in the economy
• Lower interest rates implies diminished attractiveness of
investment opportunities
• Consider the trend in interest rate movements and predict the
attractiveness of investment opportunities

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Budget deficit and management of the

public debt
• Budget deficit calls for either government borrowing or money
printing or both
• Large domestic borrowing may drive interest rates up, which
then crowds out private borrowing and investing
• Increased money supply unaccompanied by increased
production could result in undesired inflation

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Sentiments of consumers and producers

• The optimism or otherwise of consumers and producers can
affect the performance of the economy

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Demand and supply shocks

• Demand shocks
• Events that affect demand for goods
and services in the economy
• When aggregate output moves in the
Valuator sums up the impact of same direction as inflation and interest
rates
economic conditions on the
subject company into demand • Supply shocks
and supply shocks • Events that affect productive capacity
and costs
• When aggregate output moves in the
opposite direction of inflation and
interest rates

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Government Monetary policy

economic policy • Government’s manipulation of
the money supply to stimulate the
❑ Central Governments use
monetary and fiscal policy to macroeconomy
stimulate the macroeconomy to
achieve desired level of
employment and inflation Fiscal policy
❑ Governments employ
expansionary and contractionary
polices at different times to • Government’s spending and tax
achieve different results actions aimed at stimulating the
❑ However, economies may go economy
through good and bad times

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The business cycle

The business cycle

refers to the recurring
pattern of recession
and recovery
Screenshot from Investments and Portfolio Management by
Bodie, Kane, and Marcus (p.569)

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Economic indicators of the business cycle

Leading Coincident Lagging

indicators indicators indicators

Economic indexes Economic indexes Economic indexes

that tend to vary that tend to move that move
ahead of the rest of in tandem with the somewhat after the
the economy broad economy broad economy
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• Leading indicators • Coincident indicators

• Average weekly hours of production workers • Employees on non-agricultural payrolls
• Initial claims for unemployment insurance • Personal income less transfer payments
• Manufacturers new orders • Industrial production
• Fraction of companies reporting slower delivery • Manufacturing and trade sales
• New private housing units authorised
• Lagging indicators
• Yield curve slope
• Average duration of unemployment
• Stock prices, GSE Composite
• Ratio of trade inventories to sales
• Money supply (M2) growth rate
• Change in index of labour cost per unit of
• Index of consumer expectations output
• Average prime rate charged by banks
• Commercial and industrial loans
outstanding
• Ratio of consumer instalment credit
outstanding to personal income
• Change in CPI for services

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The Industry

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Industry analysis

Sensitivity of the industry to

the business cycle What industry factors
affect the prospects of
Intensity of competition
within the industry the firm?
Stage in the industry lifecycle

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Why carry out industry analysis?

The success of a firm is linked to the success of the industry

It will be difficult for the firm to succeed in an ailing industry

Performance varies widely across industry

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How do we define the industry in which

the firm operate?
We may have a good understanding of what “industry” mean,
but we may struggle to classify firms into industry groups
International Standard Industrial Classification (ISIC) of All
Economic Activities

North American Industry Classification Scheme (NAICS)

The Global Industry Classification Standard (GIPC)

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The industry and Consider the

sensitivity of the
the business cycle firm’s industry to
the business cycle

The prospects of industries are

affected by the business cycle in
different ways
Is it a cyclical Is it a defensive
industry? industry?

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Assessing the sensitivity of the

industry to the business cycle
Three factors influence sensitivity of
an industry to the business cycle:
Sensitivity of sales
Operating leverage
Financial leverage
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Assessing sensitivity of sales

• Little sensitivity (defensive industries)
• Necessities and essential services – foods, water, drugs, medical services
• Products with income inelastic demand – tobacco products

• Moderate sensitivity
• High sensitivity (cyclical industries)
• High-priced industrial and consumer goods – industrial machines, jewellery,
automobiles, transportation

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Operating leverage
What How

➢Operating Leverage refers to the

use of fixed-cost inputs in a firm’s % Change in NOI
operations DOL =
% Change in Revenue
➢Degree of operating leverage
(DOL) measures the sensitivity of
profit to variations in sales
revenue
➢High DOL suggests vulnerability Contribution Margin
to business cycle DOL =
NOI

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Financial leverage
What How

➢Financial Leverage refers to

the use of fixed-cost capital in % Change in NI
a firm’s financing structure DFL =
% Change in NOI
➢Degree of financial leverage
(DFL) measures the sensitivity
of net income to variations in
net operating income
NOI
➢High DFL suggests DFL =
vulnerability to business cycle NOI − Interest

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A final word on sensitivity to business

cycle
Industries with low sensitivity
• Contain low beta-stocks
• Investors enjoy lower gains in upturns and suffer lower losses in
downturns

Industries with high sensitivity

• Contain high-beta stocks
• Investors enjoy huge gains in upturns and suffer huge losses in
downturns
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Industry life cycles /1

Start-up Consolidation Maturity Relative

decline

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Analysing the industry lifecycle /2

Phase Features Prospect of Firms
Start-up A new technology or a new product ?
New and considerable investments
Consolidation Product becomes established ?
Industry leaders begin to emerge
Survivors from the start-up stage are more stable,
and market share is easier to predict
Maturity Product has reached its full potential for use by ?
consumers
Relative decline The industry might grow at less than the rate of ?
the overall economic growth or it might even
shrink
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Industry structure and performance

With the aid of Porter’s 5 determinants of competition, we
can assess the relationship among industry structure,
competitive strategy, and performance
Threat of entry
Rivalry between existing competitors
Pressure from substitute products
Bargaining power of buyers
Bargaining power of suppliers

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COMPANY ANALYSIS
Financial analysis
SWOT analysis

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Company analysis
Things to do Information needed
• Historical financial analysis • Financial/quantitative information
• Common-size obtained from financial statements,
• Horizontal or trend analysis financial analysis, forecasts
• Ratio analysis • Non-quantitative information
• Vulnerability to bankruptcy analysis obtained through site visits, surveys,
news analysis etc to assess quality of
• SWOT analysis management, quality of product,
customer satisfaction etc

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Financial analysis
Company performance analysis to asses growth or decline in key
financial items over past 5 years

Common-size analysis
Horizontal or trend analysis
Ratio analysis

Industry comparative analysis to assess risk to help with

determination of discount rate and selection of industry multiples

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Assessing significance – the common-size analysis

What How

• Analysis of the significance of each of • Income statement

the financial statement items • Express each item as percentage of
sales revenue
• Component percentages are Value of Item
computed to measure the Component % =
Value of Sales
significance of each item relative to a
base item • Statement of financial position
•Express each item as percentage of
• The base item for Income statement total assets
is Revenue Value of Item
Component % =
• The base item for the statement of Value of Total Asset
financial position is Total Assets
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➢Horizontal analysis
Assessing growth ➢Value of each item in a particular year is
expressed as percentage of the previous
or decline year’s value as under:
Value t − Valuet−1
% change = × 100%
Valuet−1
➢ Growth or decline in key
financial statement items ➢Common-base year analysis
➢A year is selected as base year, and values
may be assessed using in that year are assigned index of 100.
one of two methods: ➢Index for a value in a subsequent year is
➢ Horizontal analysis computed by dividing the value in that year
by the value in the base year as under:
➢ Common-base year Valuet
analysis Index = × 100
Valueb

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Ratio analysis Vulnerability to

bankruptcy
• Altman’s Z-score
Profitability and return to
investors
Asset utilisation
Vulnerability to business
Liquidity cycle
• Volatility in sales
Capital structure and • Degree of operating leverage
financial risk • Degree of financial leverage
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Test of profitability

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Return on sales (margin)

Profitability /1
• Gross profit margin
• Net profit margin

Assess the adequacy of the

firm’s income and profits
Return on capital used
• Return on assets
• Return on equity

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Profitability measures
Return on sales

Profit margin = EBIT / Revenue

Return on asset

Operating ROA = EBIT / Average TA

Return on equity

ROE = After-tax Profit / Average Equity

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Financial leverage and ROE

As the firm uses more and more debts in its financing structure, financial risk to
shareholders increases; and they should be compensated with higher returns

ROE increases with leverage

NB:
❑ ROA in the equation above is operating ROA (EBIT/Average TA)
❑ When ROA is less than borrowing cost, ROE falls with increased use of leverage
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Decomposition of ROE /1

The DuPont Identity

Explains the relationship between ROA and ROE

Explains the relationship among operating

efficiency, asset use efficiency and financial leverage

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Decomposition of ROE /2

Under DuPont Identity, ROE is derived as the product of profit

margin, asset turnover, and equity multiplier

ROE = (NI / TA x Rev / Rev) x TA / TE ROE

ROE = (NI/Rev) x (Rev/TA) x (TA/TE)

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The DuPont Identity

Factors that Influence ROE

Operating efficiency as measured by profit margin

Asset use efficiency as measured by total asset turnover

Financial leverage as measured by equity multiplier

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Another way of decomposing ROE

ROE is influenced by (1) tax burden, (2) interest burden, (3)

operating profit margin, (4) asset turnover, (5) leverage

ROE = (NI/Pretax profit) x (Pretax profit/EBIT) x (EBIT/Rev) x

(Rev/TA) x (TA/TE)

ROE = Tax burden x ROA x Compound leverage factor

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A final word on profitability

A higher value of one usually goes with lower value of
the other
Turnover and profit margin differ across
industries

Even within an industry, profit margin and

turnover differ across firms

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Test of liquidity

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Liquidity

Assess the ability of the firm to meet its currently

maturing obligations

Assess the firm’s ability to generate cash when

needed
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Liquidity measures

Current Measure of the extent to which current liabilities are covered by

current assets
ratio
Quick Measure of the extent to which current liabilities are covered by
immediate assets – cash, marketable securities, and receivables
ratio
Cash Measure of the extent to which current liabilities are covered by
cash and cash equivalents – cash and marketable securities
ratio
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Test of efficiency

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Asset utilisation efficiency

Assess the extent to which the

firm generates income and cash
flows from its assets

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Measures of efficiency in asset utilisation

Total asset turnover Fixed-asset turnover

• Measure of rate at which total • Measure of rate at which fixed
assets are used to generate assets are used to generate
revenue revenue

Inventory turnover days Receivables turnover days

• Measure of the average length of • Measure of the average length of
time inventory stay with the firm time it takes the firm to collect
before they are sold credit sales

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Test of solvency

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Solvency

Assess the firm’s debt burden and

ability to meet its financial
obligations

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Measures of leverage
Total debt ratio
Ratio of total liabilities to total assets

Long-term debt
ratio
Ratio of long-term debt to total long-term capital

Debt-to-equity
ratio
Ratio of long-term debt to shareholders’ equity

Equity
multiplier
Ratio of total assets to shareholders equity
(leverage)

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Measures of debt servicing capacity

Interest Ratio of EBIT less interest expense to
burden
EBIT
Interest Ratio of EBIT to interest expense
coverage

Cash Ratio of cash generated from operations

coverage
ratio to interest expense
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Assessing vulnerability to bankruptcy: The

Altman’s Z-score
• Factors • Zone classifications
• T1 = NWC / Total assets • Z > 2.9 → safe zone
• T2 = Retained earnings / Total assets • 1.23 < Z <2.9 → grey zone
• T3 = EBIT / Total assets • Z < 1.23 → distress zone
• T4 = Book value of equity / Total liabilities
• T5 = Sales / Total assets

Z-score Bankruptcy Model

𝑍 = 0.718𝑇1 + 0.847𝑇2 + 3.107𝑇3 + 0.420𝑇4 + 0.998𝑇5

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Test of market value

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Market value

Assess the value created

for shareholders

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Measures of market value

Market-to- Ratio of market price per share to book value per share
book ratio

Price- Ratio of market price per share to EPS

earnings ratio

Earnings yield Ratio of EPS to market price per share

Dividend yield Ratio of dividend per share to market price per share

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Economic value added

• A firm will be successful only when its investments yield returns
that exceed its cost of funds

• Reinvestment of profits increases share price only if the firm earns

more return on the reinvested profits than the opportunity cost of
funds

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Economic value added – calculation (1)

• The excess or shortage of earnings over the required rate of return
that investors could achieve from alternative investments of similar
risk
• It measures how funds have been used to either increase or diminish
shareholder value

• EVA = NOPAT – (Cost of capital x Capital employed)

• NOPAT is operating profit after tax adjusted for non-cash expenses

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Economic value added – calculation (2)

• Economic value added (EVA) is value added attributable to
contributors of capital (ROCE) in excess of what they require
(WACC)
• EVA can be computed as the product of total capital employed
(TC) and the spread between ROCE and opportunity cost of
capital (WACC)
• EVA = (ROCE – WACC) x TC
• * ROCE = (EBIT – Tax) / TC

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EVA and market value

• When a firm earns positive EVA, its stock price should increase
• A firm that will earn positive EVA in the future must sell at a
premium
• The premium, which is referred to as market value added (MVA),
is estimated as the present value of future EVAs

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The SWOT analysis

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SWOT analysis

Results of assessment of internal

business environment Strengths Weaknesses

Results of assessment of Opportunities Threats

external business environment

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NORMALISING THE
FINANCIAL
STATEMENTS
Comparability adjustment
Nonoperating assets adjustment
Nonrecurring adjustment
Discretionary adjustment

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Normalising the financial statements /1

Comparability To facilitate comparison between the subject company and
adjustments other companies in the industry or geographic location

Non- In principle, business assets that are not related to generation

operating of earnings would be retained by the seller or priced separately
adjustments
So non-operating assets are eliminated from the statement of
financial position

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Normalising the financial statements /2

Non- There may be items such as acquisitions or disposals, lawsuits, unusually large
expense or income which affect the financial statements significantly but are not
recurring expected to reoccur
adjustments
Such items are eliminated to obtain statements that better reflect
management’s expectation of future performance

Discretionary Owner-manager of a closely held company may be paid fair above the market
level compensation that other executives in the industry may earn
adjustments
If so, the executive pay is adjusted to industry standards

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VALUATION
APPROACHES
Asset-based approaches
Earnings-based approaches
Market-based approaches

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Valuation approaches
Asset-based valuation approach
• Operating asset value
• Liquidation value
Earnings-based valuation approach
• Earnings capitalisation
• Dividend
• Cash flows

Market-based valuation (market comparables) approach

• P/E multiple
• EBITDA multiple
• Sales multiple

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Next

Asset-based models

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Liquidation value

Asset-based • Subject company is not likely to stay in

business
valuation methods • Find the value of each disposable asset
separately

Valuators use asset-based valuation Operating asset value

methods to obtain a baseline price
• Subject company is judged to be a going
concern
• The value of the company as a going
concern is determined by its net asset
value

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Net assets
Assets Liabilities
Net method
Assets

The value of equity is value of

assets (excluding intangibles)
less liabilities
Net asset methods Value per share is therefore
the net assets divided by
shares outstanding
Balance Net realisable Replacement
sheet value value value

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Next

Earnings-based model

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Earnings-based Earnings capitalisation

methods
The value of the firm is Dividend models
estimated from its
income or cash flow
potential. Cash flow models

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Earnings capitalisation

ESTIMATE THE COMING CAPITALISE PROFITS USING AN

YEARS PROFITS APPROPRIATE CAPITALISATION RATE
𝑉0 = 𝐸1 /𝐾𝑒

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Dividend
Dividend discount models discount models

The constant dividend model Valuation of common stock

can be based on dividends
Thus, the value of a share
The constant growth rate model can be modelled as the PV
(i.e., the Gordon’s model) of future dividends

The multiple growth rate model

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The constant dividend model

As shareholders expect a constant dividend per share in
perpetuity, the value is modelled as the PV of a perpetuity

𝐷
𝑉0 =
𝑘𝑒
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Stock value with Value of Equity Stock with

growth opportunities Growth Opportunities
The earnings capitalisation and
constant dividend models assume that • Value = No-growth value +
all earnings would be paid to investors PVGO
If all earnings are paid to investors , 𝐸
there would be no opportunities for • 𝐺𝑟𝑜𝑤𝑡ℎ 𝑉0 = 𝐾1 + 𝑃𝑉𝐺𝑂
growth and earnings capacity and 𝑒
dividend would remain the same 𝐸
With some earnings reinvested, the • 𝑃𝑉𝐺𝑂 = 𝐺𝑟𝑜𝑤𝑡ℎ 𝑉0 − 𝐾1
firm would grow and investors would 𝑒
benefit from the growth opportunity • 𝐺𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 = 𝑅𝑂𝐸 × 𝑏

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The constant The value of a share is modelled

as the PV of future dividends in a
dividend growth growing perpetuity
model
𝐷1
❑ Model used to compute intrinsic value 𝑉0 =
of an ordinary share assuming an 𝑘𝑒 − 𝑔
expected growth pattern
❑ Share is assumed to be held forever
❑ This model is reasonable for companies 𝐷0 1 + 𝑔
in the mature stage. The earnings and 𝑉0 =
dividends of such companies are quite 𝑘𝑒 − 𝑔
stable

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The earnings
multiplier
Earnings multiplier (EM) approach
• (1 – b) / (ke – g) If growth in dividend is constant
then the company retains a
constant proportion of its
earnings (b) every year
The next year’s dividend (D1) is
Value formula equal to next year’s expected
EPS multiplied by the constant
dividend pay out ratio (1 – b)
൫1 − 𝑏)𝐸𝑃𝑆1
𝑉0 = = 𝐸𝑃𝑆1 × 𝐸𝑀 Thus, D1 in the constant dividend
𝑘𝑒 − 𝑔 growth model can be replaced
by (1 – b)EPS1

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Growth assumptions for firms that are yet

to reach maturity

For firms that have not reached their maturity stage, it is

reasonable to expect that their growth rate will not be constant

The growth rate for such firms can vary several times until
maturity when their growth rate stabilizes

For practical reasons, however, valuators typically divide the life

of the firm into phases of growth
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Non-c0nstant growth rate in dividend

The life of the firm is divided into phases of growth:

First, a forecast period with one or two high growth rates
in dividends is assumed (e.g., 18% in the first 3 years and
10% in the next 2 years)

Second, a terminal phase where the growth rate in

dividends stabilises at a constant is assumed (e.g., 5%
every year forever)
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The multiple growth rate model

The value of a share is modelled as the aggregate PV of future dividends in

the forecast period and the PV of the terminal value at the end of the forecast
period

𝐷1 𝐷2 𝐷3 𝑉3
𝑉0 = + 2
+ 3
+
(1 + 𝑘𝑒) 1 + 𝑘𝑒 (1 + 𝑘𝑒) (1 + 𝑘𝑒)3

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Intrinsic value is the present value of all cash

Intrinsic value of payments to the equity holder, including
equity stock to an dividends and the proceeds from the ultimate
sale of the stock
investor
An investor may expect to hold an
equity stock for a period and then
sell
In that, we have to find the intrinsic
value of the equity stock if it is to be
𝐷1 𝐷2 𝐸(𝑃)𝑛
𝑉0 = + 2
+ ⋯+
sold now (1 + 𝑘𝑒) 1 + 𝑘𝑒 (1 + 𝑘𝑒)𝑛

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Cash flow models Cash flow

models

Equity stocks can be valued based

on cash flows expected from the
Free cash flow to equity operations of the organisation

Free cash flow to the firm

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Cash flow definitions

Free cash Refers to the residual of cash flows from operations that can be
distributed to contributors of capital – shareholders and
flow to debtholders
the firm The remainder of cash flows from operations after deducting taxes,
(FCFF) capital expenditure, and net working capital requirement

Free cash Refers to the residual of cash flows from operations that can be
distributed to shareholders
flow to
equity The remainder of cash flows from operations after deducting taxes,
(FCFE) interest, capital expenditure, net working capital requirement and
loan repayments
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Estimating FCFF
Earnings before interest and tax

Less tax on EBIT (EBIT x (1 – t))

Adjustment for noncash items (e.g., depreciation, amortization, changes in

allowance for doubtful debt)
Less capital expenditure (plus salvage value received if any)

Less net working capital requirements

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Forecasting FCFF
Constant FCF1 = FCF0
FCFF

Constant FCFt = FCFt-1(1 + g)t

growth in
FCFF
Differing E.g. FCF will grow by 15% over the next three years,
growth 10% over the following two years, and 5% thereafter
rate to perpetuity
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Value of Total Capital

Valuation using
The aggregate PV of future free
FCFF cash flow to the firm @ the WACC

The value of the firm’s total capital

(total value, which is equity plus
debt) can be estimated using the
free cash flow to the firm
Value of Equity
The value of equity is derived from the value of total capital

Value of equity = Total value – Value of

debt

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Estimating FCFE
Net income (= EBIT – Net interest – Tax)

Plus noncash expenses (e.g., depreciation, amortization, changes in

allowance for doubtful debt)
Less capital expenditure

Less net working capital requirement

Less net debt paid

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Forecasting FCFE
Constant FCFE1 = FCFE0
FCFE

Constant FCFEt = FCFEt-1(1 + g)t

growth in
FCFE
Differing E.g., FCFE will grow by 15% over the next three years,
growth 10% over the following two years, and 5% thereafter
rate to perpetuity
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Valuation using the FCFE

Basis The value of equity can be estimated from future free

cash flow to equity

Computation
The value of equity is the aggregate PV of future FCFE using the cost of
equity as discount rate
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Finding the approach cost of equity

Some common approaches

•The build-up method

•Capital asset pricing model (CAPM)
•Bond yield plus approach
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The build-up approach

𝑅𝑒 = 𝑅𝑓 + 𝐸𝑅𝑃 + 𝑅𝑠 + 𝑅𝑐

• Re = expected rate of return on equity

• Rf = risk free return (20-year gvt bond rate)
• B = beta of company’s equity stock (if subject company is not listed, you may use
industry average)
• Rm = rate of return on the market portfolio
• Rs = size premium
• Rc = specific company risk

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Assessing specific company risk

• Management depth • Threats of competition
• Management expertise • Impact of economic factors
• Access to capital • Demographics of customers
• Leverage employee stability • Availability of labour
• PPE age • Technological risk
• Location • Socio-cultural risk
• Distribution system • Political risk
• Global risk

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Obtain the geared (equity) beta of a benchmark company

The CAPM
Derive the ungeared (asset) beta

Regear the asset beta to obtain an appropriate equity beta that reflects
the business risk and financial risk of the company under valuation
𝐾𝑒 = 𝑅𝑓 + 𝛽 𝑅𝑚 − 𝑅𝑓

Put the appropriate equity beta into the CAPM to obtain the
appropriate ke

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The Bond Yield Plus method

Ke = Benchmark bond yield + Premium

Variables
Benchmark bond yield Premium
• Yield on comparable company’s (or average industry) debt stock • A premium of about 5% or more to reflect financial risk
• Yield on firm’s own debt stock

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Next

Market relative (comparable) models

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Enterprise value (EV) or MVIC

Market multiples multiples
• Sales multiple: MVIC / Sales
• EBITDA multiple: MVIC / EBITDA
• EBIT multiple: MVIC / EBIT
❑ Valuation of common stock of
unlisted companies can be based
on market multiples
❑ But when subject company is not
listed a market comparable will Equity value multiple
have to be used to determine its • Net income (P/E) multiple = MVE / EPS
market value • Earnings yield = EPS / MVE
• Book value of equity multiple = MVE / Book
value of equity

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P/E multiple method

𝐕𝐚𝐥𝐮𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞 = 𝐉𝐮𝐬𝐭𝐢𝐟𝐢𝐞𝐝 𝐏/𝐄 𝐫𝐚𝐭𝐢𝐨 × 𝐌𝐚𝐢𝐧𝐭𝐚𝐢𝐧𝐚𝐛𝐥𝐞 𝐄𝐏𝐒

Justified P/E ratio is P/E of listed companies in the industry adjusted for the risk
associated with unlisted stock (e.g. lack of marketability, poor governance)

P/E ratio of listed stocks is adjusted downward to obtain the justified P/E ratio

Adjustment factor could range from 30% - 50%

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Earnings yield multiple method

𝐌𝐚𝐢𝐧𝐭𝐚𝐢𝐧𝐚𝐛𝐥𝐞 𝐄𝐏𝐒
𝐕𝐚𝐥𝐮𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞 =
𝐉𝐮𝐬𝐭𝐢𝐟𝐢𝐞𝐝 𝐞𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐲𝐢𝐞𝐥𝐝

Justified earnings yield is earnings yield of a benchmark company adjusted for the
risk associated with unlisted stock (e.g. lack of marketability, poor governance)

Earnings yield of listed stocks is adjusted upward to obtain the justified earnings
yield

Adjustment factor could range from 30% - 50%

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Dividends yield multiple method

𝐌𝐚𝐢𝐧𝐭𝐚𝐢𝐧𝐚𝐛𝐥𝐞 𝐃𝐏𝐒
𝐕𝐚𝐥𝐮𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞 =
𝐉𝐮𝐬𝐭𝐢𝐟𝐢𝐞𝐝 𝐝𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐲𝐢𝐞𝐥𝐝

Justified dividend yield is dividend yield of a benchmark company adjusted for the
risk associated with unlisted stock (e.g. lack of marketability, poor governance)

Dividend yield of listed stocks is adjusted upward to obtain the justified dividend
yield

Adjustment factor could range from 30% - 50%

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Sales revenue multiple

Sales multiple • Compute the sales multiple of the

benchmark company (Sales multiple
=MVIC/Revenue)
• Adjust the benchmark company’s sales
Useful when the firm is not making multiple to obtain a justified sales
profit but has appreciable level of
sales that could be a good base for multiple for the firm under valuation
valuation • Compute the value of total capital (MVIC
= Revenue x Sales multiple)
• Compute the value of equity (Equity =
MVIC – Debt)

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EBITDA Multiple

EBIT multiple • Compute the EBITD multiple of the

benchmark company (EBIT multiple
=MVIC/EBIT)
• Adjust the benchmark company’s EBIT
EBIT multiple is useful when dealing multiple to obtain a justified EBIT
with a private company that has a
stable profitability profile multiple for the firm under valuation
• Compute the value of total capital (MVIC
= EBIT x EBIT multiple)
• Compute the value of equity (Equity =
MVIC – Debt)

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EBITDA Multiple

EBITDA multiple • Compute the EBITDA multiple of the

benchmark company (EBITDA multiple
=MVIC/EBITDA)
• Adjust the benchmark company’s EBITDA
❑ EBITDA is useful when you need a multiple to obtain a justified EBITDA
base that is close to cash flows
multiple for the firm under valuation
• Compute the value of total capital (MVIC
❑ EBITDA = EBIT + Depreciation and = EBITDA x EBITDA multiple)
Amortisation
• Compute the value of equity (Equity =
MVIC – Debt)

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Next

Conclusion on the price

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Concluding on
the Value

❑ Usually, valuators use

several models to do the
Value based on a A weighting scale Final valuation
variety of methods is applied value

❑ And then estimate the

final price as a weighted
average of the result of
the various models

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Lecture on
Valuations

A. Essel-Anderson, CA

The end aeanderson@[Link]

+233 24 280 6155

+233 20 836 3329

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